Closed consultation

Solvency II: resolving the remaining policy issues for UK transposition

Updated 6 August 2014

This was published under the 2010 to 2015 Conservative and Liberal Democrat coalition government

1. Introduction

1.1 Subject of the consultation

Following on from the Solvency II Directive consultation issued by the Treasury in November 2011, this short consultation is intended to complete the process of consultation on how the government should implement the Solvency II Directive in the UK. Given the work to finalise Omnibus II, which amends the Solvency II Directive, the government has not been able to complete the consultation process before now. With the Omnibus II Directive coming into force on 23 May 2014, the Treasury is now working to complete the arrangements for transposition of Solvency II in order to ensure a smooth transition to the new prudential regime for insurance business.

The consultation seeks responses from interested parties, particularly UK insurance and reinsurance firms that fall within scope of the Solvency II Directive (Directive 2009/138/EC), as amended by Omnibus II (Directive 2014/51/EU).

1.2 Duration

This consultation will run for 6 weeks and the closing date for responses is 19 September 2014.

1.3 Enquiries and how to respond

Respondents are encouraged to reply via email to solvency2consultation@hmtreasury.gsi.gov.uk.

Alternatively you can reply by post to:

Solvency II Consultation
c/o Insurance and Savings Team
Financial Services Group
HM Treasury
1 Horse Guards Road
London
SW1A 2HQ

Respondents should address any of the questions in the consultation document where they feel they can make a contribution, as well as offering any further comments they may have as and where appropriate. Please provide basic contact details for yourself and any organisation you represent in your response.

If you have any questions about the consultation please contact Lee O’Rourke (Tel: 020 7270 6436) or Farook Fathah (Tel: 020 7270 4493).

1.4 Disclosure of responses

Information provided in response to this consultation, including personal information, may be published or disclosed in accordance with the access to information regimes. These are primarily the Freedom of Information Act 2000 (FOIA), the Data Protection Act (DPA) and the Environmental Information Regulations 2004. If you want the information that you provide to be treated as confidential, please be aware that, under the FOIA, there is a statutory Code of Practice with which public authorities must comply with and which deals, amongst other things with obligations of confidence. In view of this it would be helpful if you could explain to us why you regard the information you have provided as confidential.

If we receive a request for disclosure of the information you provide we will take full account of your explanation, but we cannot give assurance that confidentiality will be maintained in all circumstances. An automatic confidentiality disclaimer generated by your IT system will not be regarded as binding on the department. Your personal data will be processed in accordance with the DPA, and in the majority of circumstances, this will mean that your personal data will not be disclosed.

2. Legislative background and scope of consultation

The Solvency II Framework Directive, 2009/138/EC, was adopted in November 2009, with the new rules planned to come into force in the European Economic Area (EEA) on 1 November 2012. However, in advance of implementation, the European Commission proposed that the Solvency II legislation should be amended through the Omnibus II Directive.

2.1 Omnibus II

The Omnibus II directive was proposed in January 2011 and, amongst other things, sought to amend the Solvency II framework, or level 1 directive, in several key areas: updating the legislation to take account of new EU legislative processes introduced by the Treaty of Lisbon; bringing the Solvency II framework into line with the creation of the new European Supervisory Authorities (the ESAs); and providing for transitional arrangements to ensure a smooth transition to the new prudential regime.

The negotiations to finalise Omnibus II proved protracted and complex, necessitating the transposition and implementation dates for Solvency II to be postponed. Finally, after a series of discussions in Council, followed by negotiations at Trilogue level^{[footnote 1]}, agreement on Omnibus II was reached in November 2013. The agreement reached included a final timetable for implementation, with a deadline for transposition set for 31 March 2015 and full implementation of the new regime from 1 January 2016. The legislative process for Omnibus II was completed when the Directive was adopted on 16 April 2014.

The most significant area of policy change effected by Omnibus II was the development of the long-term guarantees package (LTGP), which sets out the quantitative rules for the treatment of long-term insurance products. The Omnibus II agreement also enabled the European Commission to proceed with finalising implementing measures to Solvency II (level 2), in the form of delegated acts. When finally adopted, these delegated acts will have direct effect as an EU Regulation and will not require transposition into national law.

2.2 Transposition process

The UK transposition process commenced in November 2011 when the government issued a consultation document on the UK legislative changes to implement the level 1 directive. The document was published alongside a full impact assessment and a draft statutory instrument.

This short consultation is intended to complete the process of consultation which began in 2011. It seeks views on two policy issues related to UK transposition of Solvency II. Firstly, on the use by undertakings of the volatility adjustment and whether it should be subject to prior approval by the regulator (the Prudential Regulation Authority). Secondly, on the approach to be adopted in removing business permissions where an undertaking fails to meet the Minimum Capital Requirement.

The PRA will also publish a consultation paper covering amendments it proposes to make to its regulatory rules, to complete its part of the transposition process, including how it intends to apply the long-term guarantee measures in its rulebook.

A further publication will take place later this year to include feedback on this and the previous Solvency II consultation document, an updated impact assessment and a final statutory instrument to be submitted for Parliamentary approval.

3. The volatility adjustment and supervisory powers

3.1 Introduction to volatility adjustment (VA)

The key policy debate during Omnibus II negotiations centred on the interaction between the market consistent approach of the Solvency II regime and the investment behaviour of insurers that write long-term insurance products. While it is essential that insurers should be adequately capitalised to withstand market-based risks, it was agreed that market consistency should not damage the ability of insurers to invest for the long-term. Trilogue parties therefore agreed a set of regulatory measures to ensure that short-term market movements are appropriately treated with regards to insurance products that feature long-term guarantees. This set of measures is known as the long-term guarantees package (LTGP).

The volatility adjustment (VA) is one of the LTGP measures, introduced to cover those insurance products which would not be eligible for the Matching Adjustment. The VA is an adjustment to the Solvency II risk-free discount rate which will be used to value insurance liabilities. In effect, it will reduce the value of a firm’s liabilities (known under Solvency II as technical provisions) and the amount of capital a firm is required to hold. While some of the detail on how the VA is to be calculated and applied is yet to be set out in Solvency II implementing measures, overall the VA will be calculated by taking the spread between the Solvency II risk-free rate and the rate of return on a ‘reference portfolio’ of assets. 65% of the risk-adjusted currency spread will then be added to the Solvency II risk-free rate used to value liabilities eligible to be covered by the VA.

3.2 Prudential considerations

As with other measures in Solvency II’s LTGP, the VA is based on the premise that insurers should not have to recognise the full extent of short-term volatility in asset prices. This is because many long-term insurance products, typically offered by life insurers, give rise to illiquid, predictable liability types which enable an insurer to hold onto its assets and ‘ride out’ periods where asset prices are depressed. The government believes that such an approach is good for policy holder protection and helps to support financial stability. As such, the UK supported the inclusion of these long-term guarantee measures during the Omnibus II negotiations.

However, the VA raises prudential issues because its design permits the measure to be applied to all liability types and not just those which would genuinely allow insurers to safely hold assets over the long term. The government’s view has been that the VA may be much less appropriate for liquid or volatile liability types, such as those where there can be sudden large claim payments, or where policyholders can surrender their policies in exchange for a guaranteed amount. In such cases, assets may unexpectedly need to be sold at depressed prices, leading to losses. If the VA is used for such products, asset losses will not have been allowed for within a firm’s technical provisions or capital requirements, meaning the firm is undercapitalised relative to the true risks it faces.

Allowing the VA to be used for products with significant surrender risk could also create an incentive for insurers to engage in bank-like maturity transformation, matching long-term illiquid assets against on-demand short-term liabilities. This could present a particular risk to financial stability since insurers would become vulnerable to depositor-run risk without being subject to the stringent liquidity requirements of the Capital Requirements Directive (CRDIV) and without having access to central bank liquidity support.

To address the prudential issues raised by the VA, Trilogue parties decided to introduce a safeguard which could be used by supervisors to help avoid inappropriate use of the VA. Article 77d of the Directive includes the option for Member States to make the VA subject to supervisory approval. This safeguard does not permit a Member State to rule out use of the VA in its jurisdiction. If applied, the safeguard requires the national supervisor to approve use of the VA on a firm by firm basis.

The government is now consulting on whether use of the VA by UK insurance undertakings should be automatic, or whether approval from the Prudential Regulation Authority (PRA) should be required before an undertaking could apply the VA.

3.3 Proposal for supervisory approval

If the government decides to introduce an approval requirement for UK insurance undertakings to use the VA, the policy aim of the requirement would be to ensure that the measure is used in a way which is consistent with the policy objective of the VA – that is the measure should be used to ensure that firms can avoid procyclical investment behaviour during periods of financial market instability. Use of the VA would not be allowed to undermine the overarching objective of the Solvency II Directive, that is the protection of insurance policy holders.

In order to achieve appropriate and prudent use of the VA, the PRA would be required to consider individual applications from insurance undertakings and to grant approval for use of the VA, providing the undertaking had satisfied the following criteria:

1. The undertaking has applied the volatility adjustment correctly to the relevant risk-free interest rate term structure. The PRA will need to be satisfied that the VA’s impact on valuation of relevant liabilities and any consequent impact on the undertaking’s regulatory capital requirements has been correctly calculated. The PRA will check that calculations have been properly made according to the requirements for the VA set out in the Directive and its implementing measures.
2. Use of the VA by an undertaking will not result in procyclical investment behaviour. The PRA will need to be satisfied that use of the VA is not incentivising the firm to take excessive risk during upturns that could be crystallised during downturns in the economic cycle. This is the key policy objective which the VA was designed to achieve.
3. Application of the VA is consistent with other applicable requirements of the Directive, including rules transposing the Directive and directly applicable delegated acts. In particular, the PRA will need to be satisfied that a firm applying to use the VA has complied with Article 44 of the Directive, which requires that the firm must have effective risk management systems and controls in place to manage the risks which could arise from use of the VA.

Annex B to this consultation document sets out the Treasury’s proposed draft of the provisions conferring the power to approve the volatility adjustment on the PRA. By way of background, the Treasury will be conferring a number of powers of approval on the PRA, for example in relation to the matching adjustment (Article 77b), the volatility adjustment (Article 77d), the classification of funds (Article 95) and full and partial internal models (Articles 112-127). We propose to group all these powers of approval into one part of the Treasury’s implementing regulations. The first chapter of that Part will then govern process and appeal rights for all the powers of approval, and an indication of the kind of provisions we intend is set out in Annex B. The second chapter will confer all the specific powers of approval on the PRA, although only the volatility adjustment is included for the purposes of this consultation. The third chapter is concerned with waivers or modifications of the PRA’s rules as a consequence of granting an approval. Where the meaning of words or expressions used in the draft provisions may not be obvious, we have included an explanation in the footnotes.

Question 1

Do you agree with the government’s proposal to implement the option provided in the Directive which would make use of the volatility adjustment subject to supervisory approval in the UK?

Question 2

Do you believe there any circumstances where automatic use of the volatility adjustment may be preferable to prior supervisory approval?

3.4 How the process for approval would operate

If the government decides that supervisory approval should be required for insurance undertakings to use the VA, this would be implemented through an approval process which would be transparent, proportionate and timely, and which would not increase regulatory requirements on insurance business beyond those already required by the Directive. The process would involve the following elements:

1. The approval process will examine material that all firms using the volatility adjustment will be required to produce under the Directive. Regardless of whether Member States decide to make the VA subject to supervisory approval, the Directive requires that all firms using the VA will be required to provide to the supervisor: (a) a written policy on the criteria for application of the VA; (b) a liquidity plan; and (c) a risk management plan covering use of the VA. To ensure that the approval process is proportionate and does not increase administrative burdens on business, the PRA would use this (and other) pre-existing material as the basis for assessing whether a firm is seeking to apply the VA in a way which is consistent with the criteria set out above.
2. The PRA’s decisions on approval will be communicated within 6 months of application. Supervisors and actuaries will assess whether to approve the VA on the basis of the criteria outlined above in accordance with established supervisory practice.
3. The PRA’s decision will be clearly communicated. The PRA will communicate its decision on approval in writing by the lead supervisor. If the PRA cannot approve a firm’s application to use the VA, the communication will include an explanation of how the criteria have not been met.

If the government decides to make the VA subject to supervisory approval, the PRA would intend to set out the approval process in a supervisory statement. This would be released with the detail of other approval processes, expected in Q4 2014.

3.5 The costs and benefits of supervisory approval for the VA

Requiring that use of the VA should be subject to supervisory approval will introduce an initial and temporary element of regulatory uncertainty for insurance undertakings that wish to apply the VA. Rather than being able to apply the measure automatically, a firm wishing to use the VA would need to develop a proposal designed to meet the criteria set out above. The firm would then need to seek approval from the PRA, with the possibility that its application could be rejected because it does not meet the criteria for appropriate use of the VA.

On the other hand, this initial element of regulatory uncertainty for individual firms wishing to use the VA might be balanced by a greater degree of regulatory certainty and confidence for the UK insurance sector overall. An approval process would help ensure that the VA is being used by the UK insurance sector in a consistent and prudent way. Indeed, knowledge that the supervisor has assessed and approved a firm’s use of the VA may give markets confidence that the measure is being used in a way which does not dilute policy holder protection and ensures the firm is adequately capitalised to absorb the risks it faces. We think this could have a positive impact on the cost of capital for UK firms.

Market confidence is a very relevant consideration given the requirements that the Directive includes for public disclosure of the impact from using the VA. The Directive requires that all firms using any of the LTGP measures should publicly disclose the quantitative impact of those measures on its technical provisions. Markets will therefore be able to assess the difference the VA makes to the valuation of a firm’s liabilities and its overall regulatory capital requirement. Where the VA results in a material reduction in the value of a firm’s liabilities and its consequent level of regulatory capital, markets may well look for reassurance that this is prudent. Supervisory approval should help to provide that reassurance.

Supervisory approval could also help to avoid costs associated from regulatory intervention to remedy imprudent use of the VA. Regardless of whether a Member State requires supervisory approval for the VA, the Directive provides for national supervisors to take regulatory action in the event that the VA is being used inappropriately, most notably by the supervisor requiring a capital add-on under Article 37 (1)(d). By helping to ensure that firms apply the VA prudently from the outset, an approval process could reduce the likelihood of intervention by the supervisor later on.

3.6 The government’s guiding principles for EU legislation

When implementing EU legislation, government departments are required to explain how they have applied the five transposition principles in the guiding principles for EU legislation. These five principles are set out below with an explanation of how an approval process for the VA would be consistent with each principle.

When transposing EU law, the government will:

a. Wherever possible, seek to implement EU policy and legal obligations through the use of alternatives to regulation.

It could be argued that ruling out an approval process for the VA would be necessary in order for transposition to be consistent with this principle. However, taking the Directive as a whole into account, the government does not believe that an alternative to regulation is possible in reality. This is because the Directive provides that national supervisors should take regulatory action to address inappropriate use of the VA. Use of the VA is therefore subject to regulation whether or not supervisory approval is required. The question is therefore what form of regulation is most likely to effective in minimising costs and regulatory uncertainty for business. The government believes that regulation for use of the VA which includes supervisory approval is most likely to achieve consistent and prudent use of the VA, reduce the need for regulatory action to address inappropriate use of the VA, and promote market confidence in the UK insurance sector’s use of the VA.

b. Endeavour to ensure that UK businesses are not put at a competitive disadvantage compared with their European counterparts.

It is not yet clear how other Member States will implement the VA as part of Solvency II transposition, but it is entirely possible that some Member States decide not to require supervisory approval and allow firms to apply the VA automatically. It could be argued that requiring supervisory approval in the UK would therefore place UK firms at a competitive disadvantage compared to firms based in other Member States that are not required to seek supervisory approval. While supervisory approval would entail some initial and temporary uncertainty around whether a firm would be permitted to use the VA, and could lead to a higher regulatory capital requirement where an individual firm is not approved to use the VA, overall the government believes that supervisory approval would help to promote the competitiveness of the UK insurance sector. Supervisory approval should help to avoid firms facing regulatory action and costs because of inappropriate use of the VA and should promote market confidence in UK firms, which could lead to a more competitive cost of capital for UK insurers overall.

c. Always use copy-out for transposition where it is available, except where doing so would adversely affect UK interests e.g by putting UK businesses at a competitive disadvantage compared with their European counterparts. If departments do not use copy out, they will need to explain to the RRC the reasons for their choice.

The government believes that there is no clear option for copy-out in this instance. Following a copy-out approach to transposition is used to ensure that transposition does not go beyond the provisions of the Directive. However, in relation to the VA, the Directive provides for two approaches – automatic application of the measure or supervisory approval - and it is for each Member State to decide which approach is appropriate. Based on the arguments which have already been set out above, the government believes that supervisory approval is the most appropriate option for ensuring correct and prudent implementation of the VA and for minimising the costs to business and policy holders that would flow from imprudent use of the measure.

d. Ensure the necessary implementing measures come into force on (rather than before) the transposition deadline specified in a directive, unless there are compelling reasons for earlier implementation.

Implementing measures for the VA will come into force on the transposition deadline for Solvency II specified in the Directive, which is 31 March 2015.

e. Include a statutory duty for Ministerial review every 5 years.

While ministerial review can be a useful check where the UK is proposing to transpose EU measures in a way which go beyond EU legislation, in this instance a review would have little relevance. The UK is obliged to implement the VA and must choose between two approaches to regulation of the measure. As a regime which includes supervisory approval would not be going beyond the requirements of the Directive, a ministerial review would add little in this instance.

Question 3

Do you agree that supervisory approval for use of the VA, as proposed in this consultation document, would be consistent with government’s guiding principles on EU legislation?

4. Our approach to de-authorisation of insurance firms

Article 144 of Solvency II is concerned with the withdrawal of authorisation for firms to carry out insurance or reinsurance business. The government explained the background to, and purpose of, Article 144 in chapter 6 of the previous Solvency II consultation. The particular issue we are consulting on here arises out of the obligation on supervisory authorities to withdraw authorisation where the undertaking does not comply with the Minimum Capital Requirement (MCR) and the undertaking’s finance scheme is manifestly inadequate, or the undertaking concerned fails to comply with an approved scheme within three months of the “observation of non-compliance with the Minimum Capital Requirement”.

In the UK, the problem of insurance and reinsurance undertakings in financial difficulties has often been addressed by “run-off” over a course of time. This means the undertaking is closed to new business, but may continue to pay claims on its existing contracts as and when they arise up to the time when all liabilities are considered to have been met. Where run-off is appropriate, it offers a number of advantages to policyholders. Firstly, by allowing claims to arise before finalising payments to policyholders, it arguably achieves a more equitable distribution of assets to policyholders. Secondly, it avoids the disadvantages inherent in the alternatives to run-off, namely transferring or liquidating the business. Transferring the business may not always be possible, at least not immediately. Liquidating the business means that all existing cover will be terminated. Apart from the immediate impact on policyholders, alternative cover may not always be straightforward to obtain or it may prove to be more expensive if the policyholder’s risk profile has changed, for example, where a person’s health has deteriorated since taking out a life protection contract. Furthermore, where an insurer has offset part of their risks through a reinsurance contract, reinsurers will typically only pay out in full when the insurer receives a claim, rather than on estimates during liquidation of what claims may arise. Where this happens, any recovery under a reinsurance contract is a matter of negotiation and may result in less being recovered for the benefit of policyholders than would be the case were the insurer’s business in run-off.

Looking at the insurance market and the wider financial sector as a whole, allowing undertakings to run-off claims and liabilities in an orderly fashion minimises disruption to the insurance market and helps to support financial stability.

Given that policyholder protection is the overarching objective of Solvency II, the government considers that Article 144 would require an undertaking to be closed to new business but would permit the firm, in appropriate circumstances, to continue to manage existing insurance contracts, subject to on-going supervision by the PRA. Where an undertaking is in run-off, the PRA would have the power to impose individual requirements on it under section 55M of FSMA, and where the PRA determines that run-off is no longer in the interests of policyholders, it must bring run-off to an end. The government’s proposed legislative approach to how the PRA might exercise its responsibilities is included in Annex B.

Question 4

Do you agree with the government’s proposed approach to the de-authorisation of insurance and reinsurance undertakings? Alternatively, what would be the consequences, particularly to policyholders, if such undertakings were not permitted to manage and pay claims on their existing insurance contracts?

1. ‘Trilogue’ – EU Council, EU Parliament and European Commission ↩